Indian corporations, like their counterparts around the world,
are working to ensure compliance with Ind AS 116 - the local
equivalent of the IFRS 16 accounting rule - which is mandated by
the Ministry of Corporate Affairs and came into effect in April
2019.1 In examining the likely impact of the standard,
the country's vibrant but highly fragmented retail sector
stands out.

The objective of Ind AS116, like IFRS 16, is to account for
lease transactions in a way that allows users to transparently
assess the amounts and timings of all cash flows, assets and
liabilities arising from a lease.2 Naturally, the new
standard is expected to have the most significant impact on the
accounting departments of lessee corporations that manage a large
number of leases. Globally, this means companies in the aviation,
software, telecom and retail sectors - which typically tend to rely
on operating leases - stand to be the most affected.

In India, the burden of complying with the new rule is likely to
fall inordinately on companies in the country's sprawling
retail sector, which is highly dependent on rental properties.
According to some estimates, the global retail industry will see a
98% median increase in debt from capitalising leases as required by
IFRS 16.3

The top 10 major retailers in India operate thousands of stores
while across India there are hundreds of smaller companies
operating, at a conservative estimate, about 25 stores each. This
means lease portfolios tend to be very large and geographically
spread out, with agreements localised to suit state-specific
laws.

The data consolidation challenge

Given this diversity, which is further complicated by varying
lease payment schedules, one of the key challenges Indian retailers
face is data-gathering. For instance, a retail company with its
headquarters and centralised accounting operations in Mumbai, will
have to deal with consolidating information on all the operating
leases entered into by its local offices around the country.

This can be a significant undertaking given that most retailers
have historically relied on accounting systems, processes and
controls run on basic spreadsheet software - with the possible
exception of the largest operators, who may have in-house
enterprise resource planning (ERP) software and the capability to
customise systems to accommodate the new lease accounting
standard.

Recognising the limitations of their systems, small players have
now begun to work with software developers – many of whom
have sprung to life to serve this very need – to help them
build accounting programmes that can handle the IFRS 16 standard.
This is a positive development as it will equip these companies to
gather, assess and manage data in a more systematic way, and make
accounting decisions required by the new standard that will have a
bearing not only on the companies' books, but also possibly
help enhance visibility on their overall operations.

Crunching numbers, Exercising judgment

Once a company's accounting department has access to the
consolidated lease information, the next challenge is for the
systems to account for the changes in the treatment of leases. With
IFRS 16 requiring that most leases, with few exceptions, be shown
on company balance sheets, one primary issue concerns whether to
account for a lease payment as a separate lease component or
not.

A lessee might elect to apply the practical expedient of
accounting - one of many available to make the transition to the
new rule easier - for a lease and the associated non-lease
component, treating it as a single lease component. If the
practical expedient is applied, the cash flows associated with the
non-lease component will increase the liability and right-of-use
asset recognised on the balance sheet.

This is determined by asset class and companies are likely to
consider the significance of the increase in relation to the effort
and complexity of obtaining the necessary information to separately
account for the lease and non-lease components. Retail and consumer
lessees with material leases will need additional processes,
controls and documentation to ensure appropriate and consistent
application of the guidance. For example, the guidance requires an
appropriate allocation based on relative stand-alone prices that
maximises the use of observable prices.

This is crucial because while earlier both lease and non-lease
components would be routed through the profit & loss (P&L)
account as a single operating expense, the new standard provides an
option to segregate assets from lease components. As a result,
combining both will result in higher capitalisation of the asset
and higher earnings before interest, tax, depreciation and
amortization (EBITDA). But, at the same time, it will result in a
higher lease liability on the balance sheet.

Companies also have to assess whether their accounting systems
can handle the separation of variable payments that are not linked
to a rate or index, and treat them as expenses through the P&L
account. In contrast, the earlier accounting standard did not
require such a separation.

Complications can also arise in determining the nature or
existence of a lease in certain transactions where the original
lessee sublets a property to another lessee, or the rented property
is relocated and the original rental contract does not specify a
physical location for the outlet - as with a portable stall or
kiosk, for example.

Terminal leases also need to be differentiated from those
carrying an option to renew under the new standard. While the old
system did not treat such leases separately, a lessee now has to
decide on a lease term in advance and whether to exercise an option
to extend the lease in the future, as this will determine the
present value of future lease payments and also how the asset is
valued.

These issues highlight the accounting judgments involved in
adhering to the new standard, as well as the potential long-term
impacts these judgments may have on the overall business. This
makes it all the more crucial that bookkeeping decisions are made
based on comprehensive knowledge of Ind AS 116, and full awareness
of its various strategic and operational implications.

Talk to us

At TMF Group, our goal is to keep you compliant with local tax
and accounting obligations through the entire corporate lifecycle,
from redefining internal functions to rapid expansion in new
markets. Whether you need help with statutory bookkeeping,
consolidated account preparation or international management
reporting, we can manage your accounting processes across any
jurisdiction without any conflict of interest. On IFRS 16, we are
here to help you with the following.

Transition assessment and
compliance: our global team of in-house experts can assess
your current and past reporting for IFRS 16 compliance and offer
direct and indirect tax compliance support in liaison with relevant
authorities for registration, returns, calculations and
recovery.

Accounting and
reporting: we can help maintain your books and records in
accordance with IFRS 16 accounting standards in multicurrency
formats and meeting relevant accounting policies used for
management reports (including IFRS 16, local GAAP).

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